Contrarianism is a rewarding investing thesis. The idea is that the market is a zero sum game. For me to win, others must lose, and vice versa. When the crowd stampedes into a trade, this explains why taking the other side of that bet is often correct.

Today, we are seeing one of the largest net short positions in the hedge fund community since 2011. Every time this level of sentiment led to a crowded bet, the market snapped back, punishing the crowd. This information is one of the primary points in the ongoing bull theses.

Bloomberg

The other argument I hear from the bull narrative is that stocks are not crashing from the ongoing, negative news cycle. They instead appear to be climbing a wall of worry as we are now approaching the 4200-resistance level.

This bull thesis holds merit, yet there is one important twist to this narrative that needs to be explained. The question is not: why is the market not breaking down on terrible news? The more important point that needs to be addressed is this: why is the market not breaking out in a meaningful way? With such an extreme allocation to short positions, as well as markets continuing to shrug off really bad news, it’s odd that we cannot meaningfully clear the 4200 – 4300 barrier.

I was beating the drum in mid-October and early November that a sizable rally was unfolding when the market was extremely bearish: “more and more signs are pointing to a bigger trend reversal underway. Several markets are in new uptrends and suggesting a push to new highs is on the horizon. This will lift all boats, but I do not expect all stocks/markets to make new highs. It’s important to identify the winners, and stick with them in these new uptrends.“

In our premium analysis, we went on a buying spree around this time, loading up on some of our leading positions. Today, after a sizable rally, we have raised a considerable cash position, and rebalanced our portfolio to coincide with the new macro that we are in.

We believe another reason the market cannot make up its mind is that the current macro environment is showing stubborn pockets of growth, which is keeping equities from falling. However, with stubborn growth comes stubborn inflation, which is preventing these markets from powering too much higher.

There’s plenty of evidence of this unhealthy bifurcation. For example, we’ve covered in the past that while Big Tech continues to power higher, underneath the hood, your more economically sensitive sectors, which tend to be early cycle sectors, are being sold aggressively.

If this is a new bull market, we need to see the coming volatility hold the SPX 3805 level and a rotation from Big Tech into these neglected sectors. This will be our signal to safely pivot for a renewed bull market.

Growth = Inflation

The chart below is looking at various economic metrics on a 3-month annualized basis. The reason I prefer this measurement is because we can see the current trend within the economy, as opposed to measuring the reading against an arbitrary month in the distant past.

The chart below helps to illustrate how pockets of growth in the US economy have stayed surprisingly resilient. Even housing is reaccelerating as well as the consumer. These are simply not the type of readings we see going into an imminent recession. This is fanning the hope that the looming recession will result in a soft landing, or possibly even no landing at all.

What these investors are failing to realized is that buoyant growth means buoyant inflation. In prior soft landing scenarios, like 2016, inflation was running well under the FED‘s 2% target, allowing them to keep rates next to 0 to defend declining asset prices. Today, the FED does not have this convenience, as inflation is far from their 2% target.

When we look at the same inflation metrics on a 3-month annualized basis, what investors should notice is how far away we are from the 2% target. In some instances, we are triple the desired target. Furthermore, these metrics have remained virtually unchanged for up to a year, and in some instances, and they have been growing sequentially.

Peak inflation is behind us, but the real battle will be getting these numbers back to the 2% target. In fact, going back in history, there is no instance where core PCE inflation backs off from an inflation impulse without a recession.

The reason markets are not breaking out in a substantial way after the 2022 bear market is because as growth and the consumer surprise to the upside, inflation becomes more problematic. We expect the FED to continue their fight against inflation by continuing to raise rates into 2023. The more they raise, and the longer they stay elevated, the higher the odds are that something gets broken in the economy.

Two Scenarios; SPX 3805 is Important

Regarding the broad market, here are two scenarios that I am tracking based on the structure from the October 2022 low. The blue count suggests that we are in the final swing before topping out with a push to new lows on the horizon. The Red count will find support above 3805 SPX, and begin a strong uptrend to new highs in the coming years.

Both scenarios see volatility returning into the summer. If this is a new bull market, we not only need to see 3805 hold, but we will need to also see a rotation from Big Tech into more economically sensitive sectors/styles, like small caps, transportation, industrials and financials.

Broad market breakouts tend to occur with most markets and sectors participating. Strong breadth expansion tends to equate to an improving economy. As a result, early bull markets tend to see economically sensitive sectors leading the way. This is simply not what we are seeing today, as the market piles into the perceived defensive Big Tech trade.

As of today, both Apple and Microsoft account for more than 14% of the S&P 500. In fact, over 25% of the S&P 500’s top 10 holdings are in Big Tech.

Ycharts

Furthermore, if we look at economically sensitive sectors, we are not seeing the type of relative outperformance that we tend to see in an early expansion cycle.

Small Caps

Note the head and shoulders pattern developing underneath a major trendline. There are no buyers at this critical support, and once it goes, the October lows will likely get taken out. Also, note the relative performance of small caps vs the S&P 500 in the green indicator below. When the green line is trending down, it means that the S&P 500 is outperforming Small Caps, while the green line trending up means that small caps are out performing the S&P 500.

Transportation

Transportation stocks continue to falter in the current macro, suggesting that we are not starting a new growth cycle, yet. They look a lot like the prior charts, with developing head and shoulder patterns forming on weak relative strength.

Industrials

Industrial stocks are the most concerning to me, at this point. They look a lot like Financials in late February, which we were warning investors about.

Twitter

What’s concerning is that we have a full bear pennant pattern completed at the February high, followed by a clear 5 wave drop into critical support. The current pattern is tracing a descending triangle pattern, which more than often, resolves to the downside.

Financials

I tend to believe that financials are leading the market down, not Big Tech leading us up. The weakness can be seen outside of the regional bank stocks, which I’ve discussed in great detail here.

While everyone focuses on the regional banks, the financial sector that tracks the biggest financial institutions in the US looks quite unhealthy, as well.

Conclusion

The main point I want to convey to investors is the more economically sensitive stocks and sectors appear to be setting up for a breakdown instead of a breakout. The markets have no reason to crash, as growth remains stubborn, but the piling into Big Tech while other sectors get sold is due to the fact that the FED cannot abandon their fight against inflation to support asset prices.

We are open to a new bull market being formed, which is our red count in the SPX chart above. In order for us to pivot, we will need to see the coming volatility hold 3805, and a rotation from Big Tech into the more economically sensitive areas of the market. This doesn’t mean tech won’t lead in a scenario where there is a rotation out of Big Tech, it only means that the market is seeing a soft landing and pricing that into equities.

The argument for the bulls is that the market is climbing a wall of worry, as the majority of the market piles into cash and short positions. We discussed the net short positions going back to 2011 to support this; however, if we pull this data back farther, we can see that the net short positions were even more extreme in late 2007.

Real Investment Advisors

That being said, there are times when the crowd is right. The damage done to the economy by the Fed’s fight against inflation will likely prove to be vast. We believe it is prudent to see how this next pullback manifests before getting too aggressive on the long side of this market.

Join I/O Fund Portfolio Manager, Knox Ridley, every Thursday at 4:30 p.m. Eastern on a webinar for Advanced Market Signals Members where he discusses the broad market as well as various tech positions the I/O Fund currently holds and is looking to buy. You can view the most recent webinar here.You can view the most recent webinar here.most recent webinar here.

Where the Market is Headed Next